Why Oil Prices Can Turn Negative?
The coronavirus pandemic caused an economic shutdown, unlike the world has ever seen. The US economy, which runs on oil, came to a halt as people followed orders to remain in their homes and not go into their offices. On April 20th, the effects of the pandemic forced crude oil prices in the futures market to sink below zero and into the negative territory for the first time in history. Oil prices plunged into negative territory. The price settled at get this negative thirty-seven dollars per barrel, which is down 305 percent, meaning people would pay you today to take their oil off their hands. West Texas Intermediate crude futures fell into negative territory. It really shocked the global economy. This was an event that was unprecedented and before it happened.
People didn’t think it was possible. It doesn’t really make sense when you try to wrap your head around it. How could you pay somebody to take oil off your hands? It’s no secret that the U.S. economy still runs primarily on oil. It’s been America’s largest source of energy since surpassing coal in 1950, with an average of 20million barrels consumed per day. It’s also an industry that, along with natural gas, supports more than 10 million jobs nationwide and contributes to7.6 percent of the GDP. America does rely on oil in many ways. It’s about 90 percent of the energy that we use in transportation. And it’s more than a third of the overall energy that we use. In fact, it’s probably going to stay that way for a lot, a lot longer. The Energy Information Agency administration predicts that going out to 2050 is still going to over a third of the energy that we’re going to use.
So how was it possible for oil to reach a negative value and what does it mean for the American economy? To understand what happened, it’s important to know how a futures contract functions. So the futures market is a way to bet on the future price of a certain commodity. So that can be oil, corn, wheat. Those are all examples of commodities and the way that a futures contract works is it’s tied to a delivery date in the future. So you are looking into a contract, both a buyer and a seller, and you are agreeing to delivery of that commodity on a certain date and at a certain price. So the way the oil market works, is it’s divided between the physical market, which is the oil itself, as well as the financial market, the financial market is made up of various futures contracts that are tied to specific grades of crude, as well as specific delivery dates.
Different types of oil from all across the world are traded by barrels in their individual market places. But two futures contracts serve as the major benchmark for oil price. Brent Crude trades oil from the NorthSea in northern Europe, setting the standard for international oil prices. While the West Texas Intermediate, or WTI, trades a specific grade of oil traded in Cushing, Oklahoma, that serves as a domestic benchmark for oil prices. A refinery might have a contract with a producer and say, we will pay you that Brent price or we’ll pay you the Brent price minus the transportation costs. Or you know that it’ll subject to negotiation. And those two are well known. It’s a shorthand if you will. And a lot of times other crudes are priced off of those crudes because they’re well, know the quality is high and has a long track record. Similar to most treated commodities, oil prices rely heavily on how much of it is available on the market. In other words, supply and demand.
Oil like just about anything else in the world is determined that prices are determined by a willing buyer and a willing seller. And so that means that as demand goes up, more people are buying it. The price will typically go up, supply stays the same, and vice versa. If supply suddenly increases, then typically the price will go down if the demand stays the same. The demand is determined by how much oil is needed at any given moment due to its crucial role in the economy. High demand has often been associated with healthy economic growth. Historically, oil demand has moved with the economy of a country. It’s been very tightly tied because almost all transportation comes from burning oil and a lot of other industrial processes use oil. So when the economy is humming along strongly, the demand goes up. And when you have a recession, the demand goes down.
On the other hand, supply is usually determined by the producers who have control over their output. Historically, the Organization of Petroleum Exporting Countries, otherwise known as OPEC, has played a crucial role in determining the supply. OPEC currently has 13 member countries, including Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela as founding members. However, a lot has changed in recent years as the U.S. surpassed both Russia and Saudi Arabia to become the world’s largest crude oil producer since 2018. Thanks to the rise in production from American shale fields. Essentially these countries and OPEC, everyone is competing for market share.
Everyone wants to produce more for their country, but also the optionality to export it to another country and especially growth regions such as China, Asia. Being an investor or a producer in the oil industry means keeping an eye on this fine balance between supply and demand, as well as the geopolitical events that could threaten the industry. Never forget about geopolitics and the impact it can have on the oil price, because that can be that X factor of why oil may have a big premium or a big discount to fundamentals that you see supply and demand. It’s because geopolitics introduces other risk factors. A historic drop occurred on April 20th, 2020, with U.S. oil prices on WTI dropped by almost 300 percent. Trading around negative 37 dollars.
What happened with oil in terms of the negative pricing in April with the futures contracts was rather unprecedented. We have seen negative prices before. For example, last year we were talking about negative natural gas prices and Waha in April 2019. But that’s more due to processing or field issues, not what is happened specifically this time with the COVID19 and in the price war. Oil prices had been under pressure since January as China battled the spread of COVID 19. When the pandemic finally reached the rest of the world, demand took a devastating hit.
People started talking about the demand going down 2 or 3 percent instead of growing by 1 or 2 percent, as was had previously been expected. But then by the time it got to the United States and all over Western Europe, the forecasts were very different. And at the trough, we probably saw demand in April bottom out, down 30 percent. So we’ve never seen anything like this, certainly in the last 40 years since world oil markets have developed. To make matters worse, a price war erupted between Saudi Arabia and Russia in early March after OPEC and its allies failed to reach an agreement on deeper supply cuts. Oil saw its worst trading day in 20, 29 years.
Yesterday, both WTI crude and Brent crude lost nearly a quarter of their value, and the S&P energy sector ended the day 50 percent off its 52 week closing high. Saudi Arabia launched a price war against other key producers. As supply remains steady while demand struck record-breaking lows. The petroleum industry quickly began running out of storage space to put their oil. Cushing plays a very big role as one of the main hubs of that commercial storage. And Cushing at the time of the negative contract was around 70, 70 percent full, and what was left was perhaps already committed. So that was a huge issue because Cushingplays one of the main roles in pricing the WTI contracts. As the delivery date for WTI grew near. And investors had nowhere to put the oil.
They soon began a massive selloff, prompting an unprecedented crash into the negative territory. WTI special in a way, because it’s tightly connected to physical oil. And so if you’re holding a contract for WTI, you’re expected to take possession of the oil. What was happening was the buyers who had bought a futures contract, which meant they had the responsibility to take delivery of the oil, recognized that that storage was filling up and they had no place to put the oil and they didn’t want the oil. And so they wanted to get out of the contract. Usually, they can get out of the contract by getting somebody else to take the oil instead at a positive price.
Cause oil’s a valuable commodity. But there was nobody who wanted to take that oil, particularly because it was located in an area that was producing way more oil than they needed. And the pipelines to move oil out of that area were completely full. The historic drop quickly sent shockwaves through the U.S. financial market. The Dow plunged by over 1,200 points over the following two days, and brokerage firms like interactive brokers reported taking a 109 million dollar hit to cover its customer’s losses. It was kind of like what happened in2000 where we’re wondering if the computers could rollover. Some of the trader’s computers couldn’t even handle the negative.
They weren’t set up for a negative. So you can imagine the disarray and the surprise, you know, that some traders faced the next morning when they looked at their margin calls or what they owed based on the severity of this drop. However, experts point out that although the event was unexpected, there was no need to panic. It was not unforeseen. The exchange itself saw it as a possibility ahead of time. They actually discussed what to do if that were to happen, reprogram their software, and so forth. And at least one major media outlet reported on it a week ahead of time before it happened. Also, some other products have gone negative in the past. Things like natural gas.
So I think it’s important to put it in perspective that while this had never happened with oil before, it was just on one particular instrument. The WTI was just for one-day and it was seen as at least a remote possibility ahead of time that it happened. It was very few contracts. There was very little trading at those prices and the price very quickly rebounded into positive territory. Now prices are very low. So that is a reflection of the fact that demand dropped tremendously and supply was not able to drop this quickly. Since then, we have seen actually production in that area of the United States drop drastically and start to catch up with the drop in demand. The price of oil has steadily recovered since the event, jumping by nearly 90 percent in May and registering the best month on record for West Texas Intermediate. However, the petroleum industry is still reeling from the effects of the pandemic.
Major companies like Chevron, Exxon, and Conoco Phillips have all announced deep production cuts. And Whiting Petroleum, once a large player in the oil industry, became the first major company to declare bankruptcy in April. The impact will likely be more severe for the U.S. shale industry that is often in heavy debt due to its high production costs. We might not see the price go negative. I think that was just a quirky event, but we could see the price drop down into the teens or 10 dollars, and then we would see a real devastation of the shale industry.
As it is, we’re still likely to see a pretty big devastation. A lot of the shale companies are going to go bankrupt because they’ve been betting on prices being50 or 60 dollars a barrel. And that would take a really massive rebound in the economy to happen. Just like any other sectors of the American economy. The health and the success of the petroleum industry now rests on how quickly and safely the U.S. can reopen for business. We know that when the economy gets back up and running and people feel safe and are able to get back to normal life, they’ll be using oil and gas products again. And our industry will be very happy to provide them.
Why Oil Prices Can Turn Negative